Capitalization by Asst Prof. Jonlen DeSa

ASST. PROF JONLEN DESA

CAPITALIZATION“Capitalization” is derived from the word Capital.

The term Capitalization refers to the total capital employed in a

business.

“Capitalization” is an important & essential ingredient of

financial plan.

The computation, appraisal or estimation of present value of

capital.

It includes the amount of capital to be collected, the relative

proportion of different securities to be issued & the

administration of the capital to be collected.

It is the sum total of share capital, long term loans, reserves and surpluses.

The term capitalization is used in case of companies or corporations.

According to Gerstenberg,

“Capitalization comprises of ownership which includes

capital stock & surplus in whatever form it may appear and

borrowed capital which consists of bonds or similar

evidences of long term debt.”

COMPONENTS OF CAPITALIZATIONCOMPONENTS OF CAPITALIZATION

a) The value of shares of different kinds

b) The value of debentures & bonds issued by the company

which are still not redeemed

c) The value of surpluses not meant for distribution

Thus, capitalization is the sum total of share capital, debenture

capital & reserves. This amount is actually invested in the

business for conducting various business activities.

THEORIES OF CAPITALIZATIONTHEORIES OF CAPITALIZATION

1. THE COST THEORY OF CAPITALIZATION

The process of estimating the total requirement of the funds

& other related costs.

The capital value of a company is arrived at by adding the

cost of fixed assets, capital regularly required & the cost of

establishing business & expenses of promotion.

All these costs become the basis for calculating the

capitalization of the company.

• Promotional Expenses = 50000• Purchase of fixed assets = 100000• Purchase of current assets = 50000 Total = 200000Thus, as per the cost theory, total capitalization total capitalization of the

firm is Rs 200000.

Hence, a firm should raise only what is required and if it can do that, it is said to be fairly balanced.

1. Useful for preparing capital plan

2. Simplicity

3. Suggests financial needs

4. Easy to understand & follow

1. Inadequate attention to the earning capacity

2. Does not suggest real worth of a company

3. Not applicable to companies with irregular earnings

4. Not applicable to running companies

A firm should be capitalized on the basis of its

expected earnings.

The worth of a company is to be measured by its

earning capacity and not by the amount of

capital raised.

A company is worth its earning capacity.

Capitalization is judged on the basis of the

earning capacity and not its costs.

The promoters have to calculate estimated earnings, and such estimated earnings need to be compared with the actual earnings of similar enterprises.

A firm should calculate only adequate amount of capital, if not it will lead to over- capitalization or under capitalization.

The promoters are required to prepare profit and loss account for the first few years.

The returns of the company, should then be compared with the actual earnings of similar companies in the same industry.

Earnings rate of return is between 10-25% (Assumed)

• Estimated earnings of a firm = Rs 100000

• Rate of return of similar enterprises = 10%

Capitalization = 100000* 100/10 = Rs 1000000

Hence, as per earnings theory, capitalization of the firm = Rs 1000000

MERITS DEMERITS

1. Convenient to going

concern

2. Provides logical base

3. Superior to cost theory

1. Calculation of

capitalization difficult

2. Not applicable to new

companies

MERITS & DEMERITSMERITS & DEMERITS

COST THEORY VS EARNINGS THEORYSr. No

Point of Difference

Cost Theory of Capitalization

Earnings Theory of Capitalization

1. Meaning Capital value is determined by adding all costs

Capital value is determined based on its earning capacity.

2. Base of Theory Based on costs incurred

Based on earning capacity

3. Applicability to new companies

New companies Existing companies

4. Calculation Easy & Simple Difficult

5. Superiority Not so Superior to Costs Theory

Over- capitalization is a major defect in the financial structure of the company.

A company is said to be over-capitalized when it raises more capital than required.

It is unable to earn a fair rate of return on its capital invested.

An over-capitalized company employs more capital than required, hence its earning capacity is less.

Its profits are not sufficient to pay a fair rate of interest, dividend or wages.

It is considered as a serious evil or defect in the capital structure.

Thus a company is said to be over- capitalized when it consistently fails to earn at a prevailing rate of return on its securities.

Over- capitalization does not mean abundance or abundance or excess of capital.excess of capital.

It may face shortage of funds.

Earnings of a firm = Rs 600000, Normal rate of return = 20%

Standard Capitalization = 600000*100/20 = 30000003000000

Actual capitalization = Rs 35000003500000 (As per Co’s B/S)

Thus, the company is over-capitalized by Rs 500000500000.

The company does not earn any return on the excess amount. It is a burden to the company.

Relates to earning capacity Testing criteria Weakness in the financial structure Different from excess capital Relative/ Comparative Concept Flexible Concept

Lower earnings for a long period of time. Lower rate of dividend paid for a long period of time. Lower market prices of shares over a long period. Existence of unused production capacity. Capital raised is more than what is required.

CAUSES OF OVERCAPITALIZATIONCAUSES OF OVERCAPITALIZATIONPromotion during inflationHeavy promotional expensesOver-estimation of earningsLiberal dividend policyOvertrading policyShortage of liquid capitalDefective depreciation policyPoor financial planningInadequacy of reservesHeavy tax burdensExtravagant managementDelay in project execution

ON THE ON THE COMPANY:COMPANY:


EFFECTS ON EFFECTS ON SHAREHOLDERSSHAREHOLDERS


EFFECTS ON EFFECTS ON EMPLOYEESEMPLOYEES


EFFECTS ON EFFECTS ON SOCIETYSOCIETY


Reorganization of capital structure Reduction in the interest rates on bonds & debentures Reduction of preferred stock Reduction of par-value of shares Improvement of the overall efficiency Repayment of loans & deposits Reduction of funded debts

Under-capitalization is another defect in the capital structure of the firm.

It is just the opposite of over-capitalization. It is a lesser evil as compared to over-capitalization. A company is said to be undercapitalized, when its profit

earning rate is exceptionally high as compared to the rate of profit by similar companies in the same industry.

The market value of its shares exceeds its book value. Even though a firm’s earnings are abnormally high, it is

undesirable.

A company is under capitalized when actual capitalization is lower than standard capitalization.

Under-capitalization does not mean inadequacy or shortage of funds.

A company is actually making effective use of its resources.

An under-capitalized company earns exceptionally high profits, its market share price increases and it pays a high rate of dividend to its shareholders.

Average Rate of Earnings = 10% Annual earnings of a given company = 500000

Standard Capitalization= 500000*100/10 = 5000000

Actual Capitalization = 4600000 (As per Co’s B/S).

Thus, the company is undercapitalized by Rs 400000

Comparative Concept Flexible Concept Different from shortage of capital High Earning Capacity

Earnings of a company are abnormally high. Shares are quoted at a high price. Rate of dividend is higher as compared to that of

similar companies.

Promotion during the period of depression Liberal depreciation policy Under-estimation of earnings Conservative dividend policy High degree of efficiency Windfall gains Increase in general price level









Splitting up of shares Issue of bonus shares Increase in par value of shares Re-appraisal of assets Issue of new shares

• A company has fair capitalization when actual capitalization & standard capitalization are equal or when the book value & the market value of shares are equal.

• A company gets return on investment which is similar to that of well-managed companies in that industry.

• Actual capitalization = Standard capitalization

• Fair capitalization represents an ideal situation.

IMPORTANCE/ BENEFITS

Ensures full utilization of capitalIdeal compromiseSuperior to over and under capitalizationFair earning capacity

Cost theory & Earnings Theory are the two theories of capitalization.

The two major defects are over-capitalization and under-capitalization.

Both are undesirable as it effects the company, shareholders, employees and the society at large.

Quick remedial measures should be taken , to correct the same.

A firm should aim at fair or balanced capital, as this is the most ideal situation and will benefit the company.

Education

Capitalization by Asst Prof. Jonlen DeSa